Interest rate financial futures and options, such as US Treasury Bond contracts and options written against those contracts, can be used as effective tools in managing duration in fixed income portfolios. Selling futures contracts or purchasing put options can accomplish the shortening of portfolio duration in anticipation of higher interest rates. Such short-term use of these instruments can be an appropriate alternative to liquidating income-producing securities intended for long-term holding periods. Purchasing futures contracts or call options can accomplish the lengthening of portfolio duration in anticipation of lower interest rates. Such short-term use of these instruments can be an appropriate strategy if the portfolio manager is temporarily unable to purchase appropriate traditional securities in order to achieve the portfolio’s duration targets.

Use of interest rate financial futures and options for purposes of short-term duration management is limited to 25% of the portfolio’s net assets, as measured by the par value of securities corresponding to the futures contracts held either in long or short positions and/or the par value of securities covered by respective option contracts. The effective duration after taking into account the use of these instruments should never be outside the upper or lower targeted duration ranges for the portfolio as contained in the retirement board’s investment objectives and policies.

There are also active markets in financial futures and options that track major stock market indices including the Dow Jones Industrial Average and the Standard & Poor’s 500. These instruments are used by institutional investors as well as mutual funds, including some of the largest index funds in the industry, as a source of short term liquidity that allows the portfolio manager to mimic the indices’ performance while keeping cash in reserve that would ordinarily be earmarked for purchase of specific equity securities. Correspondingly, they can also be used in the short-term as a way for managers to modestly reduce their portfolios’ exposure to the market in lieu of selling specific stocks. Use of futures and options for these purposes should not effectively exceed 10% of the portfolio, and use of these instruments for purposes other than as discussed here is not permitted.

Consistent with these guidelines, PERAC will approve supplementary regulations concerning Prohibited Investments (840 CMR 21.01). Retirement boards should
incorporate these changes in amended statements of investment objectives and policies.